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Commodities

What are commodities?

A commodity is something that is traded around the world in a standardised form. For example, gold and wheat are commodities because no matter where they are mined or
grown, the end product is basically the same. This means they can be traded worldwide at a standardised price.

Commodities come out of the earth and normally take the form of raw materials, agricultural goods and fuel. Because of this there's a limit to how much of a particular
commodity can be supplied, which can lead to big swings in price (i.e. high 'volatility') if actual (or anticipated) demand is higher or lower than the supply.

Ways to get a return

Because commodities are physical items that are traded, investment returns can only come from a change in a commodity's price - there's no prospect of an income.

A commodity's price is very sensitive to the supply of and demand for that commodity. Suppose bad weather hits corn crops, reducing worldwide production. If the world's
population continues to demand the same amount of corn as normal then there'll be a shortage (assuming supply normally equals demand), causing the corn price to rise until
demand once again equals supply due to people buying less. Successful commodity investing means trying to predict what will happen to the future supply and demand of a
commodity.

However, you may have noticed one problem with all this. Suppose you want to invest in 1 tonne of wheat because you think the price will rise over the next year, where
will you store it and will it last a year before turning bad? Because of these impracticalities it's rare to buy an actual commodity when investing. The two most common
routes are using futures contracts or shares. Although you can't buy shares in commodities themselves, you can buy them in companies which produce commodities or are related
to commodity production, e.g. gold mining companies for gold and companies that produce fertiliser for agricultural commodities. While such companies don't
track a particular commodity's price, they tend move in the same direction (i.e. they're correlated).

Commodity futures contracts between two people require one to buy and the other to sell a specific amount of a commodity on a specific date in future at an agreed price.
It's not just investors who use them, commodity producers e.g. farmers can use them to fix the price they'll get for their crops long before harvest, protecting
(i.e. 'hedging') them from subsequent price fluctuations.

While some futures require the physical commodity to be delivered, others simply require cash to be passed from one party to the other equal to the profit/loss made.

The current price (known as the 'spot' price) of commodity X is £80 per tonne. Mrs Foresight enters into a futures contract to buy 10 tonnes of X in six months time at
£90 per tonne, because she believes the price will be higher. When the contract is due the spot price of X is £100 per tonne, giving her a £10 per tonne profit, equal to
£100 overall (10 x £10). Had the spot price fallen to £60 per tonne, she would have lost £30 per tonne, equal to £300 overall.

Futures prices can be useful as they indicate where the market thinks the spot price of a commodity will go in future. They are also used to construct the commodity
indices used by investors to track commodity performance, often by buying the futures contracts expiring soonest and then rolling the money into the following month's
contract just before expiry. However, there's a potential glitch with this. The following month's contract price is often a little higher (ignoring changes to the spot price)
reflecting the cost of storing the commodity, insurance and financing etc. This is called 'contango'. The potential impact of contango means an Index could lose out every month
when money is rolled over, perhaps totalling several percent or more over a year. If you buy an investment that tracks a commodity Index, be aware of this.

What types are there?

Hard Commodities

Hard commodities are generally those that are mined from beneath the ground. As a result, it can take a lot of cash and several years to increase supply due to the logistics
of setting up a new mine or drilling operation. The main types are:

OilGasIndustrial MetalsPrecious Metals

Oil is one of the most important, and often volatile, commodities. Crude oil, which is priced per 'barrel' (42 US gallons) is primarily refined into the fuel that powers our
cars, trains and planes etc. but is also used in the manufacture of other products such as plastics, asphalt and lubricants.

The world's capacity to produce oil is relatively fixed in the short term and even the discovery of new oil fields may not be enough to satisfy eventual demand if emerging
countries such as China and India one day consume the same amount of oil per person as the US. However, while very long term supply could be scarce, supply currently more or
less matches global demand at 85 million barrels a day.

If current supply pretty much matches demand, why does the price vary so much?

Events such as wars, political unrest and natural disasters can temporarily hit production, reducing supply.

A group ('cartel') of oil producers (mostly Middle Eastern) called OPEC sometimes reduces supply to try and prop up (or increase) oil prices for the benefit of its members.

Some believe that a flood of financial speculators buying futures in the expectation of oil price rises can actually result in oil price rises.

It's also widely held that the cost to extract oil from the ground is increasing, which naturally results in a rising oil price over time.

Natural gas is extracted from the ground and refined into a fuel. For many of its uses gas competes with oil, which means the gas price tends to be affected by the oil
price. If the cost of oil rises then demand for gas normally increases (as it's a cheaper alternative) and vice versa.

Gas is measured in cubic feet or metres and normally priced per 1,000 cubic metres (Mcm) or 1,000 cubic feet (Mcf). One barrel of crude oil is the equivalent of about 170
cubic metres of natural gas.

The factors affecting gas prices are very much the same as those affecting oil prices.

Industrial metals are used extensively in construction and manufacturing. The most common examples are iron (accounts for 95% of all metal production), aluminium, nickel,
copper, tin, zinc and lead.

Popular uses (hence influences on demand) for industrial metals include:

Copper - piping (e.g. water), electronics and coins.

Iron - most commonly used in the form of steel for construction and the manufacture of machinery, vehicles, ships and household goods.

As developing economies (notably China) continue to grow, so the demand for (hence price of) industrial metals has soared. The global downturn has since seen prices fall
back, but many predict that the long term trend for industrial metal prices remains upwards.

Precious metals are rare, hence they command higher prices than industrial metals. The most common examples are gold, silver, platinum and palladium.

Popular uses (hence influences on demand) for precious metals include:

Gold is by far the best known precious metal. Although mine production is fairly consistent, gold supply is boosted by 'old' gold being melted down and re-used (typically
one third of total supply) and governments selling off their gold reserves. Jewellery represents the largest demand, with India, China and the Middle East topping the list.
If consumer prosperity increases in these countries you'd expect them to spend more on gold and vice versa.

Gold is also favoured by many investors as a hedge against inflation and as a safe haven during troubled times.

Precious metals are priced by the Troy ounce (about 10% heavier than a conventional ounce). The gold bars that are internationally traded (and the type you usually see in films) are called London Good Delivery bars
and weigh 400 Troy oz.

Soft Commodities

Soft commodities are generally those that are grown, i.e. agricultural produce. The main types are:

GrainsOther CropsLivestock

Grains are primarily needed to feed humans, livestock and poultry. They're one of the most important foodstuffs in the world.

Popular grains include:

Corn - as well as a foodstuff, it's also used to produce ethanol, an alternative to fossil fuel.

Wheat - primarily used to make flour.

Rice - the staple diet for billions of people around the world.

Soybeans - very versatile, can be used to produce many food types and oil.

Factors influencing the demand and supply (hence price) of grains include climate, demand for alternative fuels and the attractiveness for farmers to grow grains in
preference to other crops (i.e. relative prices).

Other crops include coffee, cocoa, sugar, cotton and fruits, such as oranges. Demand is largely determined by consumer taste. For example, the continued growth of 'coffee
culture' in Western countries coupled with increasing popularity in developing countries has led to steady annual increases in coffee bean demand.

Developing countries such as China and India could have a big impact on demand for crops such as wheat and sugar if they develop a Western palate.

Sugar can be used to produce an alternative fuel called ethanol, which tends to push up sugar prices when the price of oil is high.

Livestock are primarily used for food and fibre (e.g. wool and leather). The most common examples of livestock are cows ('cattle'), pigs ('hogs') and sheep. Some also
call poultry and fish livestock too.

High grain prices increase the cost of raising livestock (as feed is more expensive) and it may also encourage more farmers to grow grain rather than raise livestock,
further pushing up the price of livestock.

Once again, rising demand from developing countries such as China is responsible for a steady growth in global demand, which has generally kept livestock prices buoyant.

Tax

Gains on commodities are subject to capital gains tax.

How can I buy commodities?

With the exception of precious metals, it's really not practical to buy the commodity itself when investing. Most investors therefore use one of the following routes
when investing in commodities, including precious metals too:

Futures

While it's possible for private investors to buy commodities futures through a commodity broker, it's now more popular to use 'spread-betting' brokers. This approach allows
you to bet on the price movements of commodity futures. Gains are tax-free but tread carefully, as you could lose a lot more than your initial stake if the price plummets.

Shares

Rather than buy commodities themselves or futures, you could buy shares in companies than produce commodities or provide products/services to commodity producers. For example,
shares in a gold mining company for exposure to gold and shares in a fertiliser company for exposure to grains. However, be aware that it's not uncommon for such shares to
rise or fall by a greater degree than the commodity itself.

Funds

There are several types of fund that offer exposure to commodities:

Unit TrustsInvestment TrustsETFsPension

There are several unit trusts investing in hard commodities. Some may have a strong bias towards certain hard commodities over others, so it's important to check.

Commodity unit trusts buy shares in commodity companies, not futures, so expect volatility to be higher than the commodity prices themselves.

There are a handful of investment trusts that invest in hard commodities. Possible attractions for investors include lower charges than similar unit trusts and the
potential for 'gearing', i.e. the investment trust borrows money to increase your investment exposure (although gearing on commodities trusts tends to be modest).

Because investment trusts are companies listed on stock markets, their performance tends to be more correlated to stock markets than is the case with commodities. The value of an
investment trust is based on the price of its shares ('market capitalisation'), which may be different from the value of the property it owns ('net asset value'). If so,
you could pay more than the value of the net assets (a 'premium') or less (a 'discount'). This adds to volatility.

Exchange Traded Funds (ETFs) are index tracking shares traded on stock markets. They have the advantage of low charges and a wide choice of investment. The options available
for both hard and soft commodity investors are plentiful, you can even buy ETFs that 'short' a commodity (i.e. the ETF price rises when the commodity price falls).

If you buy an ETF it's important to understand which index it tracks and how that index is constructed. This will ensure you're getting exposure to the commodities you wish
to invest in. You could also suffer from 'contango', reducing your annual return versus the actual commodity price (for more details read the above commodity futures section).

While pension funds specialising in commodities are rare, you should be able to buy all the other commodity fund options mentioned if you have a self invested personal
pension (SIPP).

Commodities Jargon

Here's some of the more common commodities jargon you might come across:

Jargon

Meaning

Backwardation

When the price for immediate delivery of a commodity is higher than the price of delivery for a future date.

Brent Crude

The name given to oil produced in the North Sea and also a benchmark used for oil pricing.

Contango

When the price for immediate delivery of a commodity is lower than the price of delivery for a future date (due to storage costs, insurance and financing etc.)

Hard Commodities

Commodities that are mined from beneath the ground, e.g. oil.

Soft Commodities

Commodities that are grown, e.g. corn.

Spot Price

The cash market price for a physical commodity that is available for immediate delivery.